Sunday, 22 April 2012

Benjamin Graham: The Father of Screening

Many value investors claim to trace their antecedents to Ben Graham and to use the book on security analysis that he co-authored with David Dodd in 1934 as their investment bible. But who was Ben Graham, and what were his views on investing? Did he invent screening, and do his screens still work?

Graham’s Screens 

Ben Graham started life as a financial analyst and later was part of an investment partnership on Wall Street. While he was successful on both counts, his reputation was made in the classroom. He taught at Columbia and the New York Institute of Finance for more than three decades and during that period developed a loyal following among his students. In fact, much of Mr. Graham’s fame comes from the success enjoyed by his students in the market.

It was in the first edition of Security Analysis that Ben Graham put his mind to converting his views on markets to specific screens that could be used to find undervalued stocks. While the numbers in the screens did change slightly from edition to edition, they preserved their original form and are as follows:

1. Earnings to price ratio that is double the AAA bond yield
2. PE of the stock has to be less than 40 percent of the average PE for all stocks over the past five years
3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
4. Price < Two-thirds of Tangible Book Value1
5. Price < Two-thirds of  Net Current Asset Value (NCAV), where net current asset value is defined as liquid current assets including cash minus current liabilities
6. Debt-Equity Ratio (Book Value) has to be less than one
7. Current Assets > Twice Current Liabilities
8. Debt < Twice Net Current Assets
9. Historical Growth in EPS (over last 10 years) > 7%
10. No more than two years of declining earnings over the previous 10 years

Tangible book value is computed by subtracting the value of intangible assets, such as goodwill, from the total book value.

Any stock that passes all 10 screens, Graham argued, would make a worthwhile investment. It is worth noting that while there have been a number of screens that have been developed by practitioners since these first appeared, many of them are derived from or are subsets of these original screens.

The Performance 

How well do Ben Graham’s screens work when it comes to picking stocks? 

  • Henry Oppenheimer studied the portfolios obtained from these screens from 1974 to 1981 and concluded that you could have made an annual return well in excess of the market. 
  • As we will see later in this section, academics have tested individual screens—low PE ratios and high dividend yields to name two—in recent years and have found that they indeed yield portfolios that deliver higher returns. 
  • Mark Hulbert, who evaluates the performance of investment newsletters, found newsletters that espoused to follow Graham did much better than other newsletters.

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